Browse:

What is Discretionary Cost Ratio and How to Compute it?

SHARE ON:

Discretionary-cost ratio is used to analyze those cost that may easily be changed by management. Discretionary costs may be decreased when a company or department is having problems and desires a stable earnings trend. Discretionary costs include advertising, research and development, and repairs and maintenance.

Advertisement

There are three types of users who usually utilize discretionary ratios: (1) Financial Analysts; (2) Financial Managers; (3) Credit and Loan Officers. Each of them, with different purposes, utilize it in different ways. Therefore, each of them also has different point of views in interpreting the results they get.

So, how to compute discretionary-cost ratio and how each user us the ratio? Through this post I show you how to compute the ratio (with a light case example) and how each type of user use the ratio. Read on…

How Is Discretionary Cost Ratio Used

Financial Analysts – Financial analysts recognize that a pull-back in discretionary costs results in overstated earnings from an analytical point of view. This move may have a long-term negative effect because management is starving the company of needed expenditures. Thus, business managers should note that cost-reduction programs may sometimes eliminate those costs necessary to compete and prosper effectively.

Financial Managers – Financial managers, however, cannot always conclude that any reduction in discretionary costs is improper. The reduction may be necessary when the prior corporate strategy is deficient or ill-conceived. Further, a reduction in discretionary costs (e.g., advertising) may be appropriate when a major competitor has gone out of business.

Credit and Loan Officers – Credit and loan officers should determine if the present level of discretionary costs conforms with the company’s prior trends and with current and future requirements. Index numbers may be used in comparing current discretionary expenditures with base-year expenditures. A vacillating trend in discretionary costs to revenue may indicate that the company is smoothing earnings by altering its discretionary costs. A substantial increase in discretionary costs may have a positive impact on corporate earning power and future growth.

The declining trend in the ratio of repairs and maintenance to both sales and fixed assets indicates that the net income of the company is overstated and there is inadequate maintenance of fixed assets, leading to possible future breakdowns. Although there are short-term benefits, the situation suggests that its continuance would have a detrimental effect in future years.

Analytical Example

The following relationship exists between advertising and sales:

Years 2011 2012 2013

Sales $120,000 $150,000 $100,000
Advertising 11,000 16,000 8,000

2011 is the most typical year. Increasing competition is expected in 2014.

Advertising to sales is 9.2 percent in 2011, 10.7 percent in 2012, and 8 percent in 2013. In terms of base dollars, 2011 is assigned 100. In 2012, the index number is $16,000/$11,000 = 145.5; and in 2013 it is $8,000/$11,000 = 72.7. These are negative indicators regarding 2013. Advertising is at a lower level than in previous years. In fact, advertising should have risen due to the expected increased competition.

About AuthorLie Dharma Putra

Putra is a CPA. His last position, in the corporate world, was a controller for a corporation in Costa Mesa, CA. After spending 15 years as a nine-to-five employee, he decided to serve more companies, families and even individuals, as a trusted business advisor. He blogs about accounting, finance and tax, during his spare time, and helps accounting students (around the globe) to understand the subject matter easier , faster. Follow him on twitter @LieDharmaPutra or add him to your circle at Google Plus Lie+

No Comment

Your email address will not be published. Required fields are marked *

Are you looking for easy accounting tutorial? Established since 2007, Accounting-Financial-Tax.com hosts more than 1300 articles (still growing), and has helped millions accounting student, teacher, junior accountants and small business owners, worldwide.